Removing Distortions in the U.S. Ethanol Market:

What Does It Imply for the United States and Brazil?

Amani Elobeid and Simla Tokgoz Food and Agricultural Policy Research Institute (FAPRI) Center for Agricultural and Rural Development (CARD)

Iowa State University

Amani Elobeid Associate Scientist 567 Heady Hall Iowa State University Ames, IA 50011-1070 Ph: (515) 294-6175 E-mail: amani@iastate.edu

Simla Tokgoz Associate Scientist 560B Heady Hall Iowa State University Ames, IA 50011-1070 Ph: (515) 294-6357 E-mail: stokgoz@iastate.edu

Selected Paper prepared for presentation at the American Agricultural Economics Association Annual Meeting, Portland, OR, July 29-August 1, 2007

Copyright 2007 by Amani Elobeid and Simla Tokgoz. All rights reserved. Readers may

make verbatim copies of this document for non-commercial purposes by any means,

provided that this copyright notice appears on all such copies.

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Abstract

We analyze the impact of trade liberalization and removal of the federal tax credit in the

United States on U.S. and Brazilian ethanol markets using a multi-market international

ethanol model calibrated on 2005 market data and policies. The removal of trade

distortions induces a 23.9 percent increase in the price of world ethanol on average

between 2006 and 2015 relative to the baseline. The U.S. domestic ethanol price

decreases by 13.6 percent, which results in a 7.2 percent decline in production and a 3.8

percent increase in consumption. The lower domestic price leads to a 3.7 percent rise in

the share of fuel ethanol in gasoline consumption. U.S. net ethanol imports increase by

199 percent. Brazil responds to the higher world ethanol price by increasing its

production by 9.1 percent on average. Total ethanol consumption in Brazil decreases by

3.3 percent and net exports increase by 64 percent relative to the baseline. The higher

ethanol price leads to a 4.9 percent increase in the share of sugarcane used in ethanol

production. The removal of trade distortions and 51¢ per gallon tax credit to refiners

blending ethanol induces a 16.5 percent increase in the world ethanol price.

Keywords: biofuels, ethanol, renewable fuels, trade liberalization

JEL code: F13, F17, Q17, Q18, Q42

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Removing Distortions in the U.S. Ethanol Market:

What Does It Imply for the United States and Brazil?

In the past few years, interest in biofuels has greatly increased, which can be attributed to

environmental, economic, and geo-political factors. Harmful emissions, high crude oil

prices, and the growing dependency on foreign oil supplies all have provided incentives

for pursuing alternative fuel sources, such as ethanol and biodiesel. Furthermore, the

rising importance of biofuels can also be attributed to the desire by countries to develop

new markets for agricultural products. This push is currently policy driven, for example,

in the United States through the U.S. Energy Bill of 2005 and in the European Union

(EU) through the Renewable Fuels Directive of 2003. Even Brazil, an established

producer and consumer of ethanol, promoted its ethanol industry through an ethanol

program, the National Alcohol Programme (PROALCOOL), which was launched in the

mid-1970s.

Ethanol is the most visible of the biofuels that is benefiting from this recent surge

in interest. It can be produced from a variety of feedstocks such as cereals, sugarcane, and

cellulosic material. In general, renewable fuels are more expensive to produce than fossil-

based fuels, and so both production and consumption have been encouraged for the most

part with government policy intervention through mandates and/or market incentives.

The U.S. and Brazil are currently leading the way in the use of ethanol as an

alternative fuel. Ethanol production and consumption in both countries have been

increasing rapidly in recent years. In 2005, Brazil produced 4.8 billion gallons of ethanol

and the U.S. produced 3.9 billion gallons, making these countries the two largest

4

producers in the world, accounting for over 90 percent of the total world production.

In addition to the 2005 Energy Bill, which introduced a Renewable Fuel Standard

(RFS), the recent rise in demand for ethanol in the U.S. has been fueled by higher crude

oil prices and the replacement of MTBE (methyl tertiary butyl ether) with ethanol as an

additive in refining. The volatility of domestic ethanol prices and the occasional spikes in

price caused by this recent hike in demand for ethanol have led to discussions of

eliminating the tariff on ethanol imports to the U.S. In this context, this article has two

objectives. The first is to set up an international ethanol model and to create a baseline.

The second is to analyze the impact of the removal of trade and domestic distortions in

the U.S. on the world ethanol market.

There are a limited number of studies on ethanol markets, as the industry has

experienced a boom only in recent years. Gallagher et al. (2006) look at the competitive

position of Brazilian ethanol produced from sugar processing vis-à-vis the U.S. ethanol

produced from corn under the assumption of no tariffs in the ethanol market. The results

suggest that there are no trends, but there are cyclical periods of advantage for both

industries. Koizumi and Yanagishima (2005) establish an international ethanol model and

examine the implications of a change in the compulsory ethanol-gasoline blend ratio in

Brazil on world ethanol and sugar markets. Their simulation suggests moderate impacts

on both markets. Gallagher, Otto, and Dikeman (2000) analyze the impact of introducing

a minimum oxygen content for fuel in Midwestern states. The study finds that ethanol

can compete with MTBE in the oxygenate market with the aid of federal tax incentives

for ethanol blending. The loss in federal tax revenues is offset by the benefits gained by

5

consumers, producers, and local economies.

This article offers a number of contributions to the literature on ethanol. The first

contribution is that, in addition to examining the impact of trade liberalization in the U.S.

on international ethanol markets, we also endogenize the prices of crops used in ethanol

production, i.e., sugar and corn, which previous studies have tended to hold constant

(Gallagher et al., 2006; Koizumi and Yanagishima, 2005). To achieve this, the

international ethanol model is linked to an international sugar model and a U.S. crops

model. Given that the ethanol market is an emerging one with evolving policies being

implemented by a number of countries, this study provides analysis using recent policy

settings and provides insight to how these policies will affect the future of the ethanol

industry. An original approach in this study is the explicit modeling of the linkage

between the agricultural commodity markets and the energy markets. Furthermore, we

address the issue of ethanol acting as both a substitute and a complement to gasoline and

how this affects the direction of the impact from policy change. Since data on ethanol is

currently very limited and sparse, this article further contributes to the existing literature

by utilizing a multitude of data from different sources, which have been extensively

scrutinized to provide the most cohesive data for analysis.

In the following paragraphs, we describe the U.S. and Brazilian ethanol markets

and provide a brief discussion on the relative competitiveness between the two countries’

ethanol sectors. Then, we explain the structure of the international ethanol model used for

the simulations as well as the country-specific models for the U.S. and Brazil. After

having introduced the policy reform scenario, we present the key results of our

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simulations.

The study finds that the removal of trade distortions in the first scenario induces a

decrease in the U.S. domestic ethanol price, which results in a decline in U.S. ethanol

production and an increase in consumption. Consequently, U.S. net ethanol imports

increase significantly. The resulting higher world ethanol price leads to an increase in

ethanol production and a decrease in total ethanol consumption in Brazil causing net

exports to increase relative to the baseline. In the second scenario, the removal of trade

distortions and the 51¢ per gallon tax credit to refiners blending ethanol results in a lower

increase in the world ethanol price relative to the first scenario.

Overview of U.S. and Brazilian Ethanol Markets

The U.S. Ethanol Market

In the U.S., ethanol is produced primarily from corn using either a wet-milling or a dry-

milling process. Wet mills produce ethanol and the by-products corn gluten meal, corn

gluten feed, corn oil, and CO2. Dry mills, which are the predominant mill-type, produce

ethanol with dried distillers grains (DDG) and solubles and CO2 as by-products (Coltrain,

2001; Tiffany, 2002). The recent boost in ethanol demand is largely the result of several

states banning the use of a gasoline additive called MTBE, as it is suspected of

contaminating drinking water. Another boost to ethanol demand comes from the U.S.

Energy Bill of 2005. The recent increase in crude oil and gasoline prices has also opened

a new market for ethanol as a fuel extender (Eidman, 2006).

There are numerous state and federal legislations that affect the U.S. ethanol

market. One of the earliest is the Energy Tax Act of 1978, which introduced the motor

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fuel excise tax exemption that gives ethanol blends of at least 10 percent by volume a 40¢

per gallon exemption on the federal motor fuels tax. Since then, various tax laws have

been adopted to change the level of tax credit, which currently stands at 51¢ per gallon

through 2010. The Energy Policy Act of 1992 extended the fuel tax exemption to two

additional blend rates containing less than 10 percent ethanol; i.e., 5.7 percent and 7.7

percent. It also created a number of alternative-fueled vehicle requirements for

government and state motor fleets to encourage biofuel use. The Clean Air Act

Amendments of 1990 established the Oxygenated Fuels Program and the Reformulated

Gasoline Program, which in turn increased ethanol demand as an additive. The Energy

Policy Act of 2005 introduced RFS, which requires U.S. fuel production to include a

minimum amount of renewable fuel each year, starting at 4 billion gallons in 2006 and

reaching 7.5 billion gallons in 2012. After 2012, renewable fuel production must grow by

at least the same rate as gasoline production. The Energy Policy Act also eliminated the

oxygenate requirement for reformulated gasoline (Duffield and Collins, 2006; Yacobucci,

2006a).

The U.S. trade policy on ethanol includes an ad valorem tariff of 2.5 percent as

well as an import duty of 54¢ per gallon. One of the objectives of the tariff is to ensure

that the benefits of the domestic U.S. ethanol tax credit do not accrue to foreign

producers. The other important trade policy that affects ethanol imports is the Caribbean

Basin Economic Recovery Act (CBERA) that groups Central American countries with

Caribbean countries. This Act created the current import rules for ethanol under the

Caribbean Basin Initiative (CBI). Under this agreement, if ethanol is produced from at

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least 50 percent agricultural feedstock grown in a CBERA country, it is admitted into the

U.S. free of duty. If the local feedstock content is lower, limitations apply on the quantity

of duty-free ethanol. The amount of ethanol that can be imported duty-free that is

produced from non-CBERA agricultural feedstock is restricted to 60 million gallons or 7

percent of the U.S. domestic ethanol market, whichever is greater. To comply with this

requirement, hydrous ethanol is imported to a CBI country and is dehydrated before it

can be exported to the U.S. Dehydration plants are currently operating in CBI countries

such as Jamaica, Costa Rica, and El Salvador, where hydrous ethanol produced in other

countries, historically Brazil and Europe, can be dehydrated before it is exported to the

U.S. (Yacobucci, 2006b).

In 2005, U.S. ethanol production capacity was 4.3 billion gallons from 95 ethanol

refineries. Capacity expansion totaled 0.2 billion gallons, while capacity under

construction was 1.8 billion gallons. Ethanol production consumed 1.4 billion bushels of

corn (about 12.6 percent of U.S. corn production) in 2005. According to this study’s

baseline projections, 3.3 billion bushels of corn are expected to be utilized by 2015 (about

24.9 percent of a 13 billion bushel crop). Thus, ethanol production has already exceeded

the 2006 target of the renewable fuels mandate. Despite the rapid increase in production,

consumption of ethanol has been outpacing production for the past few years, which has

led to increased imports into the U.S.

The Brazilian Ethanol Market

Brazil is currently the world’s largest producer of ethanol, deriving its supply from

sugarcane. Brazil is one of the first countries to promote ethanol widely through its

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National Alcohol Program, which was launched in late 1975 in response to high oil prices

and declining sugar prices (Bolling and Suarez, 2001). The program was intended to

reduce Brazil’s dependence on foreign oil and to find alternative markets for Brazilian

sugar. The government implemented mandates on the blending ratio of ethanol with all

gasoline sold in Brazil. It also promoted the production of ethanol by offering credit

guarantees and low-interest loans for construction of new plants and by setting ethanol

prices at favorable levels relative to gasoline. This resulted in a dramatic increase in

ethanol production by the end of the 1970s. The ethanol sector was further boosted by the

introduction in 1979 of ethanol cars that ran on hydrous ethanol. The government also

provided incentives to citizens to drive ethanol cars.

The Brazilian ethanol program flourished during the early 1980s. By the mid-

1980s, however, world oil prices fell and Brazil faced severe economic difficulties.

Support for the ethanol program was drastically cut and ethanol production began to

decline. By the late 1980s, sugar prices began to recover and sugar became more

profitable. As a result of the decline in ethanol production, along with the significant

number of ethanol cars in use, Brazil experienced a serious shortage of ethanol in 1990

and the country was compelled to import ethanol to meet demand. Consumers lost

confidence in ethanol and the sale of ethanol cars declined significantly. The setting of

ethanol prices was eliminated and the industry was deregulated by 1999 (Brilhante, 1997;

Moreira and Goldemberg, 1999).

The Brazilian government currently provides support to ethanol production

through both market regulations and tax incentives. In terms of market regulations, a

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blending ratio of anhydrous ethanol with gasoline of between 20 and 25 percent in

transport fuel is imposed. There are also credit provisions for ethanol storage, in the form

of a lower excise tax for ethanol than for gasoline and through the use of strategic

reserves. Imports of ethanol to Brazil are subject to an ad valorem duty of 20 percent.

Ethanol in Brazil is produced from low-cost sugarcane and therefore can compete with

gasoline on a production-cost basis without any subsidies.

Recently, increased demand for ethanol in Brazil has been driven by the

popularity of flex-fuel cars that can run on gasoline, ethanol, or a combination of the two.

Flex-fuel vehicles and ethanol vehicles, which run only on hydrous ethanol, both enjoy

some tax incentives not offered to gasohol cars that run only on gasoline blended with

ethanol at the mandate set by legislation. The sale of flex-fuel cars has increased

dramatically (by 585 percent in 2004) since their introduction in 2003. The share of flex-

fuel cars in vehicle fleet reached 22 percent in 2004, 40 percent in 2005, and is expected

to rise to 60 percent in 2006. Flex-fuel vehicles are expected to be the predominant

vehicle type in Brazil while ethanol vehicles are expected to diminish to insignificant

numbers within the next decade (F.O. Lichts, 2006b).

In Brazil, a large number of plants are dual plants producing both sugar and

ethanol, and they can switch easily between the production of sugar and ethanol based on

relative prices.1 Thus, sugar and ethanol prices have tended to move closely together,

whereas in the U.S., movement in ethanol prices is affected primarily by the gasoline

market and by government regulations. In the past few years, the relative price of sugar

and ethanol has favored more sugarcane diverted to ethanol production rather than to

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sugar production. With the increased demand in ethanol both domestically and

internationally, the share of sugarcane used in ethanol production is expected to rise

steadily.

In 2005, production of sugar and ethanol in Brazil totaled 28.2 million metric tons

and 4.8 billion gallons, respectively, continuing a record trend for the past few years. The

record production has resulted in the export of 18 million metric tons of sugar and 0.6

billion gallons of ethanol in 2005. Baseline projections show that ethanol production in

Brazil is expected to increase by 48.5 percent while ethanol exports are expected to

nearly double by 2015. If both sugar and ethanol prices remain competitive in the near

future, Brazil is expected to continue to increase sugarcane production for both sugar and

ethanol. The country has enough land to significantly increase sugarcane area harvested.

Competitiveness of U.S. versus Brazilian Ethanol Sectors

The cost of ethanol per gallon of fuel from sugarcane in Brazil, at 83¢ per gallon of fuel,

is lower than the cost from corn in the U.S., at $1.09 per gallon (von Lampe, 2006). In

addition to the higher cost of production, there are additional costs in the U.S. associated

with transporting ethanol from the production locations in the Midwest to major

population areas, particularly in the coastal regions. This has led to an increase in the

competitiveness of Brazilian ethanol imports despite the steep tariffs in the U.S.

Furthermore, volatility in U.S. domestic ethanol prices, which sometimes leads to spikes,

provides Brazil with the opportunity to export ethanol to the U.S. For example, in

October 2005 the Brazilian anhydrous ethanol price was $1.38 per gallon. Adding freight

and the import tariff, the price for ethanol would reach $2.07 per gallon (including the

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11¢-per-gallon transportation cost), which was below the $2.47 per gallon U.S. domestic

price for the same month. Consequently, Brazil was able to export 5.2 million gallons of

ethanol to the U.S. in October, up from zero exports in August and 2.7 million gallons in

September 2005. In total, Brazil exported 86.5 million gallons of ethanol in 2004 and

65.9 million gallons in 2005, becoming the major source of U.S. ethanol imports

(Renewable Fuels Association, 2006).

Structure of the International Ethanol Model

The international ethanol model is a non-spatial, multi-market world model consisting of

a number of countries/regions, including a Rest-of-World aggregate to close the model.

The model specifies ethanol production, use, and trade between countries/regions.

Country coverage consists of the United States, Brazil, European Union-15, China, Japan,

and a Rest-of-World aggregate. The model incorporates linkages to the agriculture and

energy markets, namely U.S. crops, world sugar, and gasoline markets.

The general structure of the country model is made up of behavioral equations for

production, consumption, ending stocks, and net trade. Complete country models are

established for the U.S., Brazil, and the EU-15, while only net trade equations are set up

for China, Japan, and the Rest-of-World because of limited data availability. The model

solves for a representative world ethanol price (Brazilian anhydrous ethanol price) by

equating excess supply and excess demand across countries. Using price transmission

equations, the domestic price of ethanol for each country is linked with the representative

world price through exchange rates and other price policy wedges. All prices in the

model are expressed in real terms. Through linkages to the U.S. crops and world sugar

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models, we also endogenously solve for all the U.S. crops prices including the U.S. corn

farm price and its by-products (High Fructose Corn Syrup, DDG, etc.). Furthermore, the

world raw sugar price is solved endogenously by equating excess supply to excess

demand in the world sugar market. It is important to note that since this is a new area of

investigation, the limited data availability dictates the modeling approach.

U.S. Ethanol Model

Ethanol Demand

Total U.S. ethanol demand is divided into fuel-ethanol demand and a residual demand

that consists of non-fuel alcohol use (industrial and beverage). Fuel-ethanol demand is a

derived demand from the cost function for refiners blending gasoline with additives,

including ethanol. Given that only aggregate data is available on U.S. motor gasoline

consumption, we are constrained to model an aggregate composite gasoline production

representing all types of gasoline available on the U.S. market. Let C denote the cost

function for the refiners supplying all types of gasoline blended with additives, including

gasoline blended with ethanol. We abstract from the time dimension when not necessary.

The cost function is written as ( , , , )US US USE O GSC C P P Policy Q= , where US

GSQ is the

refiners’ output, which is the gasoline supply, USEP is the domestic price of ethanol, US

OP

is the U.S. price of crude oil, and Policy is federal and state legislations that impact

refiners’ ethanol demand. Under the constant-returns-to-scale assumption, the cost

function can be written as ( , , )US US USE O GSC C P P Policy Q= ⋅ . The marginal cost ( GMC ) of

gasoline is constant as long as input prices are constant. Gasoline output USGSQ is

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eventually determined by the intersection of gasoline demand and the marginal cost of

gasoline ( GMC ) at the equilibrium in the gasoline market. By Shephard’s lemma, the

intermediate demand for fuel ethanol, ( USEC P∂ ∂ ), is derived as

(1) US USF GSUS US

E E

C CE QP P

⎛ ⎞∂ ∂= = ⋅ ⎜ ⎟∂ ∂⎝ ⎠

,

where USFE is the fuel ethanol demand in million gallons and / US

EC P∂ ∂ is the derived

demand for ethanol per unit of gasoline. Accounting for the specific policy interventions

affecting refiners, we obtain the following equation:

(2) ( , , , )US US USE oUS

E

C f P TR P Mandate RFSP∂

= −∂

,

where USTR stands for the tax rebate of 51¢ per gallon that refiners get when they blend

10 percent ethanol with gasoline, Mandate is the requirement of ethanol blend in

percentage in certain states, and RFS denotes the Renewable Fuels Standard created by

the Energy Bill of 2005 in million gallons.

USGDQ denotes the Marshallian demand for gasoline in the U.S. market, that is, the

amount of gasoline consumption used in transportation in million gallons. It is expressed

as:

(3) ( , , , )US US US US US USGD G EQ g P P TR GDP Pop= − ,

where USGP is the price of unleaded gasoline in dollars per gallon and is a function of US

OP .

USGP is included in equation (3) as final consumers see the unleaded gasoline price.2

USGDP is real gross domestic product (GDP) in 1995 U.S. dollars, and USPop is

15

population. Consumers respond positively to a decrease in the price of the composite

fuel, which is a function of the prices of gasoline and ethanol. The ethanol component of

the composite aggregate fuel consumption increases as the ethanol price falls relative the

price of gasoline to capture the substitution between the types of gasoline at the gas-

station pump.

In equilibrium in the gasoline market, quantity of gasoline supplied by refiners is

equal to the quantity of gasoline demanded by final consumers ( USGDQ ), i.e.,

US US USGS GD GQ Q Q= = . Substituting equations (2) and (3) into equation (1) yields the derived

demand of ethanol evaluated at the equilibrium of the gasoline market, *USFE :

(4) * ( , , , ) ( , , , )US US US US US US US US USF E o G EUS

E

CE f P TR P Mandate RFS g P P TR GDP PopP∂

= = − ⋅ −∂

At the equilibrium of the gasoline market, / USEC P∂ ∂ can be interpreted as the share of

fuel ethanol in total gasoline consumption ( * /US USF GDE Q ).

In U.S. gasoline production, fuel ethanol is mainly used as an additive to gasoline.

In this regard, ethanol acts as a complementary good to pure gasoline. However, in

demand, ethanol is a substitute to gasoline, through the introduction of E85 cars, which

run on gasoline blended with up to 85 percent ethanol, and because of the recent use of

ethanol as a fuel enhancer induced by high gasoline prices. In this analysis, through the

parameterization of equation (4), it is assumed that the complementary relationship is

more dominant than the substitute relationship because currently ethanol is blended only

at 10 percent and is not available in all states. Furthermore, E85 cars represent a

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negligible portion of the U.S. vehicle fleet. Substitution effects are currently limited but

may get larger in the future if E85 cars become popular. To reflect the complementarity,

an increase in the price of gasoline translates into a net decrease in demand for

ethanol *USFE . The coefficient estimate for US

oP in equation (2) is positive compared to the

coefficient estimate of USGP in equation (3), which is negative. The former effect is

smaller than the latter in absolute value.

The magnitude of the complementary and substitute relationships also depends on

the assumptions made about the composition of the U.S. vehicle fleet in the future. As

long as the number of flex-fuel (E85) vehicles in the U.S. remains relatively small, there

is only limited substitution for regular cars in terms of substituting gasoline for

ethanol. Finally, to complete the specification of total ethanol demand, the residual

ethanol demand is simply set up as a function of the U.S. domestic ethanol price.

Ethanol Supply

To model the domestic ethanol production in the U.S., we use a restricted profit function

for the ethanol plants. Both wet and dry mill plants use mainly natural gas as an input in

the process. Profit maximization under capacity constraint yields a profit function, which

can be expressed as function of a return per bushel of corn net of energy cost. To account

for the different processes of ethanol production, the relative marginal revenues from the

by-products from each process is weighted by the share of production by each mill type;

DMs is the share of dry mill production in total ethanol production, and WMs is the share

of wet mill production. Thus, the net return per bushel of corn for ethanol plants in the

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U.S., NETπ , is expressed as:

(5) ( (( ) ( ) ( )))NET US US US USE E WM GF GF GM GM CO COP s P P Pπ γ γ γ γ= ⋅ + ⋅ ⋅ + ⋅ + ⋅

( ( ))US US USDM DDG DDG C NGs P P m Pγ+ ⋅ ⋅ − + ⋅ .

In equation (5), USGFP is the price of gluten feed in dollars per ton, US

GMP is the price

of gluten meal in dollars per ton, USCOP is the price of corn oil in dollars per gallon, US

DDGP is

the price of DDG in dollars per ton, and USCP is the price of corn in dollars per bushel.

,USNG tP is an index of the price of natural gas, which is multiplied by m=0.0038 to scale the

index to dollars per bushel of corn. The conversion rates ( iγ ) are used to convert each

price to dollars per bushel of corn.3

This allows us to construct the ethanol production function ( USY ) as

(6) ( , )US NETY h PCπ= ,

where PC denotes the production capacity in million gallons.4 The equation for the

production capacity is ( )t t 1 tPC PC 1 g−= ⋅ + , where tg is the endogenous growth rate of

this capacity and t denotes the time period. We model the growth rate as

(7) ( , ( )) 35¢

0

NET NETt 1 E t 1

tk E D if per bushel

gOtherwise

π π− −⎧ >= ⎨⎩

,

where ( )EE D is defined as the expected future demand that investors project for ethanol

and 35¢ per bushel is the trigger fixed cost of building a new ethanol plant expressed per

bushel of corn. This cost estimate is obtained from industry sources. In the U.S.,

production capacity has been increasing at an unprecedented pace, which prompted us to

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set up the above capacity equation and to incorporate the expectations of investors on

future profits.

Inventory Demand

Next, the ending stock ( UStES ) equation is expressed as follows:

(8) ,( , )US US USt t 1 E tES m ES P−= ,

where the coefficient estimate for ,USE tP is negative.

Ethanol Trade

The trade equations consist of export and import equations. Because U.S. ethanol exports

are small, they are kept constant. U.S. ethanol imports are the sum of imports from CBI

countries ( CBIM ) and imports from other countries ( OtherM ). The CBI countries in this

article include only Costa Rica, El Salvador, and Jamaica. For the CBI countries, there is

a tariff rate quota (TRQ) rule. The in-quota tariff rate is iτ , which is zero. The out-of-

quota tariff rate is oτ , which is 2.5 percent plus 54¢ per gallon. The TRQ is set at 60

million gallons or 7 percent of U.S. consumption, whichever is greater. We set up the

CBI import equation based on the relative world ethanol price to the domestic U.S. price

as follows:

(9) ( )

( ( ) )

( ( ) )

US W AE E

USUS W AE

CBI E EW AE

CBI

Capacity if P P 1 tc

PM if P P 1 tcP 1 tc

M 0 Otherwise

θ τ

α β φ ττ

⎧ > ⋅ ⋅ + +⎪

⎛ ⎞⎪= + ⋅ > ⋅ ⋅ + +⎜ ⎟⎨ ⎜ ⎟⋅ + +⎪ ⎝ ⎠⎪ =⎩

,

where Capacity is the CBI countries’ maximum capacity of their dehydration plants, and

tc is the transportation cost. θ and φ are transmission coefficients that are both less than

19

one, and φ θ< . They are included to account for the transaction costs between firms, the

time lag between contracts and delivery, and the daily volatility in ethanol prices which

are not captured in the annual price data. Transportation cost ( tc ) is 11¢ per gallon.5 For

CBI, tc also includes the transformation (dehydration) costs. In the above equations,

A iτ τ= if CBIM TRQ≤ , and A oτ τ= if CBIM TRQ> .

Imports from other countries are subject to the out-of-quota tariff rate of 2.5

percent plus 54¢ per gallon. The import equations for other countries are as follows:

(10) 0 ( ( ) )( )

US W oE E

Otherif P P 1 tc

MDemand Supply Otherwise

φ τ⎧ < ⋅ ⋅ + += ⎨

−⎩,

where supply is the sum of production, beginning stocks, and imports from CBI

countries, and demand is the sum of consumption, ending stocks, and exports.

Through equations (9) and (10), we see that when the tariff is not prohibitive,

import demand is positive making the domestic U.S. price dictated by the world ethanol

price through a price transmission equation. When the tariff is prohibitive and there are

no imports from other countries, the domestic U.S. price is solved endogenously within

the model, equating excess supply to excess demand. Hence, to account for this, we

construct a price switching regime. The domestic price of ethanol can be either solved

endogenously ( EndogenousEP ) or it can be a price transmission from the world price of

ethanol. If ( )Endogenous W oE EP P 1 tcτ> ⋅ + + , then the domestic ethanol price equals

( )W oEP 1 tcτ⋅ + + . If ( )Endogenous W o

E EP P 1 tcτ< ⋅ + + , then the domestic ethanol price is

EndogenousEP .

20

Brazil Ethanol Model

Ethanol Demand

In Brazil, the ethanol demand is divided into anhydrous and hydrous ethanol demand, as

they respond to different economic incentives depending on the three types of vehicles

(alcohol, flex-fuel, and gasohol cars). The alcohol vehicles use only hydrous ethanol, the

gasohol vehicles use only anhydrous ethanol, while the flex-fuel vehicles can use both

hydrous ethanol and anhydrous ethanol (blended in gasoline). Therefore, we model

anhydrous ethanol demand ( BAE ) and hydrous ethanol demand separately ( B

HE ), where

total ethanol demand in Brazil BTotalE equals ( )B B

H AE E+ .

The behavioral equations for anhydrous and hydrous ethanol consumption are

given as follows:

(11) ( , , , , , )B W B B BA E GE n P P I GDP Pop Blend=

(12) ( , , , , , )B W B B B BH E GE p P P I GDP Pop F= ,

where WEP represents the price of Brazilian anhydrous ethanol in reals per gallon, which

is also the world ethanol price. Although there is a price for hydrous ethanol, only one

price for ethanol, namely anhydrous, is used in both demand equations. The two prices

are highly correlated as in general, the price of anhydrous ethanol is the price of hydrous

ethanol plus the cost of dehydration, which is assumed constant. BGP is the price of

gasoline in reals per gallon, and I is an interaction term that is equal to BGP times the

ratio of flex-fuel cars in the total vehicle fleet. BF denotes the number of flex-fuel cars in

the vehicle fleet in units. BGDP and BPop are the GDP in 1995 reals and population for

21

Brazil, respectively. Blend is the mandate of 20–25 percent. The interaction term I is

used to capture the higher demand responsiveness of flex-fuel cars to changes in the price

of gasoline. As the number of flex-fuel cars increases in the projection period, the

demand for both anhydrous and hydrous ethanol becomes increasingly responsive to the

change in the price of gasoline. In the case of anhydrous demand, as the price of gasoline

rises, the demand for ethanol declines as flex-fuel cars substitute hydrous ethanol for

gasoline blended with anhydrous ethanol. So the coefficients for BGP and I in equation

(11) are negative. Conversely, for the demand for hydrous ethanol, if the price of gasoline

increases, the demand increases as flex-fuel cars increase their use of hydrous ethanol

relative to anhydrous ethanol blended in gasoline. Hence, the coefficients for BGP and I

in equation (12) are positive.

Ethanol Supply

In modeling the supply of ethanol in Brazil, the link between sugar and ethanol markets is

critical as ethanol is produced from sugarcane in Brazil. So, ethanol and sugar compete

for sugarcane. Therefore, the derived demand for sugarcane that goes into ethanol

production comes from the profit maximization problem of sugarcane producers.

In the Brazilian sugar model, we obtain the area harvested for sugarcane in Brazil

( CtAHA ) from the cane producers’ profit maximization, which is given as

(13) , , ,( , , , )C C B B Bt t 1 S t E t AC tAHA q AHA P P P−= ,

where ,B

S tP is the price of sugar in reals per ton (the Caribbean FOB raw sugar price times

the exchange rate), and ,B

AC tP is the price of competing crops (namely, soybeans) in reals

22

per ton. Sugarcane production is area harvested for sugarcane multiplied by the yield. In

the ethanol model, the behavioral equation for the share of sugarcane in ethanol

production ( CES ) is given by

(14) B

C EE B

S

PS rP

⎛ ⎞= ⎜ ⎟

⎝ ⎠,

where the coefficient estimate for the ratio of prices is positive. Sugarcane used in

ethanol production equals CES multiplied by total sugarcane production. Ethanol

production equals sugarcane used in ethanol production times the conversion rate of

22.98 gallons per metric ton of sugarcane.

Inventory Demand

The ethanol ending stock ( BtES ) equation is constructed as

(15) ,( , )B B Bt t 1 E tES v ES P−= ,

where the coefficient estimate for ,B

E tP is negative.

Ethanol Trade

Net exports are derived as a residual, i.e., equal to production plus beginning stocks

minus consumption minus ending stocks. Although there is an ethanol import tariff in

Brazil, it is not incorporated into the model, as Brazil is a net exporter of ethanol.

Model Calibration, Data Source, and Variables

The model is calibrated on the most recent available data (2005), and then generates a 10-

year baseline to 2015. The model combines econometric and consensus estimates of

supply and demand responses to their respective arguments (prices, price of related

23

products, income, etc.).6 In general, data for ethanol supply and utilization were obtained

from the F.O. Lichts Online Database, the Food and Agricultural Organization (FAO) of

the United Nations (FAOSTAT Online), the Production, Supply and Distribution View

(PS&D) of the U.S. Department of Agriculture (USDA), and the European Commission

Directorate General for Energy and Transport. Macroeconomic data such as real GDP,

GDP deflator, population, and exchange rate were gathered from various sources,

including the International Monetary Fund and Global Insight (formerly WEFA-DRI).

Production, consumption, export, import, and stock data for the U.S. were taken

from F.O. Lichts. To split the total ethanol demand into its two components, we use data

on U.S. total ethanol consumption from F.O. Lichts, and data on the share of corn going

into fuel alcohol use and into other fuel alcohol use from the U.S. Department of

Agriculture’s Economic Research Service. U.S. ethanol import data are divided into

imports from different countries according to the U.S. International Trade Council data

set. U.S. production capacity was obtained from the Renewable Fuels Association’s

Annual Industry Outlook publications. The U.S. ethanol price is the FOB average rack

price for Omaha, Nebraska, provided by the Nebraska Ethanol Board. The unleaded

gasoline price is the FOB average rack price for Omaha, Nebraska, provided at the same

website. The crude oil price is the refiners’ acquisition cost of imported crude oil

obtained from Energy Information Administration (EIA) Short-Term Energy Outlook

May 2006, and Annual Energy Outlook 2006 publications. U.S. gasoline consumption is

the finished motor gasoline demand (that includes ethanol and ethers blended into

gasoline) from EIA’s Short-Term Energy Outlook May 2006 and Annual Energy Outlook

24

2006 publications. As a proxy for expected future demand projected by ethanol investors,

we used a five-year average of ethanol demand projected five years into the future

provided by the EIA’s Annual Energy Outlook 2006. The corn price is the farm price

from the USDA National Agricultural Statistics Service online database. The natural gas

utility price index was from Global Insight. The DDG price (Lawrenceburg), gluten meal

price (60 percent, IL Pts), and gluten feed price (21 percent, IL Pts) were from the USDA

Economic Research Service Feed Situation and Outlook Yearbook. The corn oil price

(Chicago) was from USDA Economic Research Service Oil Crop Yearbook and Oilseed

Outlook.

Most of the data for Brazil, including ethanol supply and utilization data as well

as ethanol and sugar prices, sugarcane data, and Brazilian gasoline consumption, were

obtained from the Attaché Reports of USDA’s Foreign Agriculture Service. Ethanol

prices are for anhydrous ethanol provided on a monthly basis for the State of São Paulo,

Brazil. Sugar prices include tax in the domestic market. Data for anhydrous and hydrous

ethanol consumption is not available separately, so anhydrous ethanol consumption data

was computed using the formula B BA G

BlendE Q1 Blend

⎛ ⎞= ⋅ ⎜ ⎟−⎝ ⎠, where Blend is the mandate of

20–25 percent, BAE denotes anhydrous ethanol consumption in million gallons, and B

GQ is

gasoline consumption for Brazil in million gallons. Flex-fuel and other vehicle data were

obtained from the Brazilian Automotive Industry Yearbook (ANFAVEA, 2005) and

vehicle projections were obtained from UNICA, 2006. In the Brazilian ethanol model, the

gasoline price is the U.S. gasoline price obtained from EIA’s Annual Energy Outlook

25

2006 publication converted to local currency per gallon.7

Reform Scenarios and Results

We consider two scenarios as deviations from the baseline. The first scenario is the

removal of the trade distortions in the U.S. The out-of-quota duties of 2.5 percent and 54¢

per gallon are removed for all U.S. ethanol imports. For CBI countries, the TRQ is also

eliminated. The second scenario removes the trade barriers and the federal tax credit for

refiners that blend ethanol with gasoline. Although this credit is 51¢ per gallon, the

effective tax credit of 5.1¢ per gallon is removed as that is what the final consumer sees

since the ethanol is blended mostly at 10 percent. In each scenario, the policy reforms are

fully implemented in 2006 and their impact is measured in deviations for the years 2006

to 2015. We report the average of these annual changes as a summary indicator of the

impacts. Table 1 summarizes the impacts on the world market and presents the detailed

impacts on the U.S. and Brazilian ethanol markets for the first scenario; table 2 presents

the impacts for the second scenario.

Scenario 1: Impact of Trade Liberalization

With the removal of the duties, the U.S. domestic ethanol price decreases by 13.6

percent, which results in a 7.2 percent decline in ethanol production and a 3.8 percent

increase in consumption. The lower domestic price leads to a rise in the share of fuel

ethanol in gasoline consumption by 3.7 percent. Given the lower domestic ethanol price,

consumers are substituting gasoline blended with ethanol for gasoline blended with other

additives. The removal of trade distortions in the U.S. and the corresponding higher U.S.

ethanol demand increases the world ethanol price by 23.9 percent on average over the

26

simulation period (table 1).

Net imports of ethanol in the U.S. increase by 199 percent. Given that net imports

make up only 5.3 percent of domestic consumption in the baseline, the large increase in

net imports in the first scenario translates to a 15.1 percent share of imports in total U.S.

domestic consumption. Since the duties are removed, Brazil can now export ethanol to

the U.S. directly without having to go through the CBI countries. Therefore, trade

diversion occurs, and we assume that ethanol imports from CBI countries decline to zero

and that Brazil makes up for the decline with higher exports to the U.S. However, it is

possible that some ethanol imports may continue to come from CBI countries. If ethanol

prices are competitive, CBI countries may use domestic feedstock to produce ethanol for

exporting to the U.S.

The lower domestic production of ethanol translates into a reduced demand for

corn in the U.S. Thus, the corn price declines by 1.5 percent on average relative to the

baseline. Given the decline in corn used in ethanol production, the production of by-

products decreases, by 7.1 percent on average for DDG, and by 1.7 percent each for

gluten feed, gluten meal, and corn oil. The reduction in the production of DDG increases

the price of DDG by 0.7 percent. The price of gluten meal increases by 0.9 percent

because of its production decline. However, the prices of gluten feed and corn oil fall by

0.5 percent and 0.2 percent, respectively, as the impact from the lower corn price, which

decreases the cost of production, exceeds the impact from lower production.

Brazil responds to the higher world ethanol price by increasing its production by

9.1 percent on average relative to the baseline. Total ethanol consumption decreases by

27

3.3 percent and net exports increase by 64 percent. The higher ethanol price leads to an

increase in the share of sugarcane used in ethanol production by 4.9 percent. This results

in less sugarcane used in sugar production, which decreases sugar production in Brazil.

The lower supply of Brazilian sugar leads to an increase in the world raw sugar price by

1.8 percent on average.

Scenario 2: Impact of Trade Liberalization and Tax Credit Removal

In this scenario, in addition to the removal of the tariffs in the U.S., the 51¢-per-gallon

federal tax credit is also removed. The simulation results are presented in table 2. U.S.

ethanol consumption decreases by 2.1 percent as the tax credit for refiners is removed.

The U.S. domestic ethanol price decreases by 18.4 percent, which is higher in this

scenario relative to the first scenario, since U.S. ethanol consumption is lower. In

response to the lower domestic price, production decreases by 9.9 percent compared to

the 7.2 percent decline in the first scenario. The world ethanol price increases by 16.5

percent on average compared to the baseline, which is also lower than in scenario 1. The

impact on the corn by-products market is similar to that in the first scenario, particularly

in direction.

Conclusions

There has been a great deal of interest in ethanol as a renewable fuel because of the surge

in demand in the U.S., higher crude oil prices, and the U.S. Energy Bill of 2005, which

introduced a renewable fuel standard. Given the importance of the impact of trade

distortions on U.S. ethanol markets, this article attempts to contribute to the discussion by

analyzing a trade liberalization scenario as well as the effect of removal of domestic

28

distortions. This article also addresses the complex relationship between gasoline and

ethanol, with ethanol acting as both a substitute and a complement to gasoline.

We use a multi-market international ethanol model that is calibrated on 2005

market data and policies to investigate the impact of the U.S. tariff removal on prices,

production and consumption, and trade. Ethanol is an emerging market, currently driven

primarily by regulations and mandates, with Brazil and the U.S. leading the way. Trade

distortions are an important contributor to the distortions in commodity markets, with

large price and consumption effects. The study finds that trade barriers in the U.S. have

been effective in protecting the ethanol industry and keeping domestic prices strong.

With the removal of trade distortions, the world ethanol price increases, as demand for

ethanol, and therefore imports, increases in the U.S. Imports to the coastal regions in the

U.S. would increase significantly with trade liberalization, as transportation costs of

ethanol from the Midwest are high. Thus, Brazil, with its comparative advantage of low-

cost ethanol production, would benefit from the removal of the U.S. duties. Given that the

CBI countries are currently an indirect route for Brazilian ethanol exports to the U.S.,

these countries could see a significant reduction in their exports since Brazil would be

able to ship ethanol directly to the U.S. without duties.

The effect of the removal of trade distortions extends beyond the ethanol market,

affecting the corn market and its by-products, as well as the sugar market. The price of

corn in the U.S. is impacted by the change in the demand for corn used in ethanol

production. The prices of other crops in the U.S. are also affected, as well as the area

allocation between them. This has implications for the U.S. livestock sector because the

29

prices of feed by-products from ethanol production change as well as the prices of other

feeds such as the price of soy meal.

Brazil is a major player in the world ethanol market where both gasoline and

sugar prices play an important role in determining what happens. The tariff rate in the

U.S. is approximately 45 percent in ad valorem terms, which means that if it were

eliminated, the U.S. market would become very attractive to Brazil. Under this scenario,

with the increase in the world ethanol price, more sugarcane is diverted toward the

production of ethanol and thus, the price of raw sugar rises. Ethanol and sugar in Brazil

compete for sugarcane. Depending on the prices of ethanol and sugar, Brazil may end up

increasing both the production of ethanol and sugar by expanding sugarcane area. Brazil

could produce and export more ethanol than is projected in this study given stronger

assumption on its ability to increase sugarcane production through acreage expansion, its

potential to increase ethanol production capacity, and future investments in infrastructure.

The second scenario adds the removal of the federal tax credit for refiners

blending ethanol to the removal of the trade barriers in the U.S. The marginal impact of

the tax credit removal is a reduction in the refiners’ demand for ethanol, prompting a

reduction in imports and a corresponding decline in the world ethanol price. Thus, the

final effect of the removal of both the tariff and the tax credit is a lower increase in net

imports of the U.S. relative to the first scenario and a lower increase in the world ethanol

price.

Given the emerging nature of the ethanol markets, our analysis comes with some

caveats. Data availability and consistency is limited, which has led to the combination of

30

different data sets. Various data sources have different definitions for ethanol variables.

In addition, the time series for ethanol data is very short, making econometric estimations

difficult. Within this brief time period, there have been radical changes (e.g., policy

changes, crude oil price hikes) in the ethanol sector that have inherently changed the

relationship between variables, such as the link between the ethanol and gasoline

markets, and the ethanol and crops markets. In terms of modeling, constructing the U.S.

production function is complicated by the rapidly increasing production capacity of

ethanol in the U.S. To accommodate for this, we used a proxy for investors’ expectations

of future ethanol demand, which is an ad hoc method of modeling forward-looking

expectations. Although we remove the tax credit at the federal level, there are various

state level regulations targeting ethanol that are not incorporated into the aggregate U.S.

model. It is also important to note that the increasing popularity of flex-fuel cars in

Brazil, and to a lesser extent in the U.S., may change the dynamics of how ethanol

markets respond to a price change. As the number of flex-fuel cars increases, the

complementary relationship between gasoline and ethanol becomes less pronounced

while the substitution effect becomes stronger. This in turn changes the demand response,

which may change the results of our policy scenarios. Within this framework of a fast-

changing ethanol market, we have attempted to model and analyze the underlying

fundamentals of the ethanol market.

31

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35

Table 1: Impact of Removal of U.S. Trade Barriers on U.S. and Brazilian Ethanol MarketsAverage 2006-2015 (US$/cwt) (US$/bushel) (US$/ton) (US$/ton)World Ethanol Price Crude Oil Price Raw Sugar Price Corn Price DDG Price Gluten Feed Price

Baseline 1.27 1.39 14.34 2.38 78.47 58.80 Scenario 1 1.57 1.39 14.59 2.34 79.00 58.50 % chg from baseline 23.89% 0.00% 1.77% -1.53% 0.68% -0.50%

(US$/gallon)Gasoline Share of Fuel Ethanol in Domestic

United States Production Consumption Net Imports Consumption Gasoline Consumption Ethanol Price

Baseline 7,063.80 7,458.87 396.04 152,796.54 0.046 1.95 Scenario 1 6,563.66 7,730.73 1,169.05 152,962.58 0.048 1.68 % chg from baseline -7.23% 3.75% 199.04% 0.11% 3.74% -13.57%

Anhydrous Hydrous Total Share of Sugarcane Brazil Production Consumption Consumption Consumption Net Exports in Ethanol Production

Baseline 6,164.54 1,443.50 3,574.47 5,017.97 1,146.92 0.534 Scenario 1 6,730.05 1,410.04 3,444.13 4,854.18 1,877.14 0.560 % chg from baseline 9.10% -2.32% -3.74% -3.32% 63.96% 4.87%

(US$/gallon)

(Million Gallons)

(Million Gallons)

Table 2: Impact of Removal of U.S. Trade Barriers & Federal Tax Credit on U.S. and Brazilian Ethanol MarketsAverage 2006-2015 (US$/cwt) (US$/bushel) (US$/ton) (US$/ton)World Ethanol Price Crude Oil Price Raw Sugar Price Corn Price DDG Price Gluten Feed Price

Baseline 1.27 1.39 14.34 2.38 78.47 58.80 Scenario 2 1.48 1.39 14.51 2.33 79.20 58.39 % chg from baseline 16.51% 0.00% 1.22% -2.10% 0.94% -0.69%

(US$/gallon)Gasoline Share of Fuel Ethanol in Domestic

United States Production Consumption Net Imports Consumption Gasoline Consumption Ethanol Price

Baseline 7,063.80 7,458.87 396.04 152,796.54 0.046 1.95 Scenario 2 6,384.51 7,310.96 928.74 152,699.71 0.045 1.59 % chg from baseline -9.92% -2.12% 136.97% -0.06% -2.26% -18.38%

Anhydrous Hydrous Total Share of Sugarcane Brazil Production Consumption Consumption Consumption Net Exports in Ethanol Production

Baseline 6,164.54 1,443.50 3,574.47 5,017.97 1,146.92 0.534 Scenario 2 6,553.90 1,420.39 3,484.43 4,904.82 1,650.07 0.552 % chg from baseline 6.26% -1.61% -2.58% -2.29% 44.01% 3.39%

(Million Gallons)

(Million Gallons)

(US$/gallon)

36

Endnotes

1 The switch between ethanol and sugar in these dual plants is restricted to a maximum of

60 percent in either direction.

2 Although there exist several types of gasoline available to consumers, we use the price

of unleaded gasoline as a proxy for a composite gasoline price since all types of gasoline

prices are highly correlated.

3 The conversion rates for each by-product are tons per bushel, whereas the conversion

rate for ethanol is gallons per bushel. One bushel of corn creates 2.8 gallons of ethanol,

0.0057 ton of gluten feed, 0.0015 ton of gluten meal and 0.0008 ton of corn oil through

the wet mill process, or it generates 2.8 gallons of ethanol and 0.0087 ton of DDG

through the dry mill process on average.

4 The exit decisions by firms are not modeled.

5 The transportation cost estimate is calculated based on industry sources and various

market reports (EIA, 2004; F.O. Lichts, 2006a; USDA AMS, 2006).

6 Details on the model including elasticity values are available from the authors upon

request.

7 The U.S. crude oil and gasoline prices are assumed to be the world prices for crude oil

and gasoline, respectively. These prices are used in the Brazilian model because of lack

of access to Brazilian fuel price data.